When Foreclosures Are Good for the Housing Market

NEW YORK ( TheStreet) -- The foreclosure crisis is far from over, but it may no longer be a threat to the recovery of the housing market.

While millions of homes remain in the foreclosure process, there are now other factors such as a shortage of housing inventory and strong demand from investors and traditional home buyers that might provide some support for the housing market.

Foreclosures have been on the decline in the past two years. Fewer borrowers have defaulted on their loans. Banks have also pursued alternatives to foreclosures amid new state laws designed to protect borrowers.

Newly initiated foreclosures dropped 11% in January and are down 28% from a year ago, according to the latest report from RealtyTrac released Thursday.

Market observers, however, do not expect foreclosures to go away anytime soon.

A big reason for the drop in January was the Homeowner Bill of Rights that took effect in California. The bill bans dual tracking -- where banks foreclose on borrowers while simultaneously negotiating a loan modification -- and requires a single point of contact for borrowers. It also imposes a $7,500 fine per loan for filing of unverified foreclosure documents.

The tougher rules meant that "the downward foreclosure trend in California accelerated into hyper speed in January," according to RealtyTrac's Daren Blomquist.

But such borrower-friendly laws have not really stopped foreclosures; they've merely slowed them down.

Blomquist talks of the "boomerang" effect in states such as Washington and Nevada where laws similar to the one in California have been passed.

"These states have seen a big drop off at the outset when these laws are passed. There is a foreclosure hiatus for 12 to 18 months, but then the numbers bounce back," he said.

In Washington for instance, after the "Foreclosure Fairness Act" that promoted mediation for homeowners took effect in July 2011, foreclosure filings plunged. But now foreclosure starts are back at a 26-month high.

Blomquist believes the California law will likely have a similar effect. "The foreclosures that are left now are inevitable. They need to happen. We can't save everyone from foreclosures."

This is, of course, not good news for borrowers in default who may be hoping to stay in their homes.

But, ironically, a steady supply of foreclosed homes might actually help buyers in most markets.

The number of homes available for sale at the end of 2012 was at an 11-year low, according to National Association of Realtors. According to data from Realtors.com, inventory declined 16.5% from a year earlier in January.

The shortage of homes available for sale is driving prices higher, resulting in bidding wars in some cities and sparking concerns that another bubble might be starting.

Rising home prices should normally encourage more Americans to sell their homes to trade up, but the crisis has left millions owing more than their homes are worth. Many are still on the fence, waiting for prices to move up further so that they can sell at a profit.